The basic principle of profit distribution among investors
Profits are distributed proportionally to each investor's share in the company's capital. For example, if an investor owns 20% of the company, they are entitled to 20% of the net profit after a sale or liquidation. However, in venture capital deals, this logic is often complicated by additional conditions, such as liquidation preferences, priority of return of funds and different classes of shares.
The traditional equity model involves investing capital for a share. If the company's value grows, so does the value of your share. Upon exit, the profit is calculated by subtracting the invested funds from the share's sale price. It is important to note, however, that different investors may have different entry conditions. For instance, funds typically receive preferred shares, which entitle them to priority repayment of their investment.
In venture capital, this is critical due to the extremely high risk. Most startups never reach the exit stage. Therefore, investors protect themselves through the deal structure. This is where the waterfall model comes in — a cascading distribution of funds.
Whether you invest directly or through a fund, you should always pay attention to the following:
- Share class.
- Liquidation preferences.
- The presence of participating or non-participating mechanics; and
- The fund management company's share of carried interest.
Understanding these principles will help you to manage your expected return more effectively.
How to calculate the investor's profit?
The profit calculation formula
The basic formula looks like this:
Profit = Sale price of the share – Investment amount.
ROI is calculated using the following formula:
ROI (%) = (profit/investment amount) × 100%.
If you invested $100,000 and received $350,000 upon exit, then:
Profit = $350,000 – $100,000 = $250,000.
ROI = (250,000/100,000)×100% = 250%.
Investment multiplier:
Multiple = Return amount / Investment amount
In this case: 350,000/100,000 = 3.5x
These three indicators provide a comprehensive overview of the investment effectiveness.
Calculating profit using a practical example
Suppose you invested $200,000 in an early-stage startup and received a 10% stake in the company. Five years later, the company was sold for $20 million. Your share is:
10% × $20,000,000 = $2,000,000.
Your net profit would be $1,800,000 ($2,000,000 – $200,000).
The multiplier is $2,000,000 ÷ $200,000 = 10x.
ROI: ($1,800,000 ÷ $200,000) × 100% = 900%.
However, if the deal structure includes liquidation preferences for other investors, the actual payout may be lower. It may also change if your share has been diluted. This is why you need to analyse the cap table before entering into a deal.
Profit distribution sequence (waterfall model)
The waterfall model is a cascading mechanism for distributing funds; it determines who receives payments and in what order after the company sale. It is widely used in venture capital and private investment funds.
The essence of the model is that profits are not distributed simultaneously, but in stages. First, the invested capital is returned, then any minimum guaranteed return (if applicable), and finally, the remaining profit is divided between investors and the management company.
This approach disciplines the fund and protects investors. Managing partners receive their share (carried interest) only after investors have recouped their investment and reached a certain return threshold.
Stage one: return on investment
During this phase, investors receive their money back in full from the sale of an asset. This is called a 'return of capital'.
For instance, if a fund raises $10 million and sells an asset for $12 million, the initial $10 million is returned to investors proportionally to their contributions. Only then does the distribution of profits begin.
This mechanism significantly reduces the risk for the fund's limited partners (LPs). They know that management will not receive a bonus until the capital has been repaid.
Stage two: distribution of the remaining profits
Once the investment has been returned, the remaining funds are considered profit. This is where carried interest comes into play. It is typically 20% for the management company and 80% for the investors.
In the above example, the profit is $2 million. If the carried interest is 20%, then:
- $400,000 goes to the management company;
- $1,600,000 is distributed among the investors.
This creates a fair model in which investors are protected, and management is motivated to achieve high returns.
What is liquidation preference, and how does it impact profit distribution?
What is liquidation preference?
Such a preference is the legal right of an investor to get a specific sum if the business is sold, merged, or liquidated. Most often, this amounts to 1x the invested capital.
This means that the investor is entitled to recover the full amount invested before the remainder is distributed among the other shareholders. If 2x is stipulated, the investor receives double the amount.
This mechanism is especially important in cases of a so-called'soft exit', in which a company is sold for a price that is only slightly higher than the funds raised. The liquidation preference in these situations dictates whether the founder will get any compensation at all.
It is also essential to understand that the preference only applies in the event of liquidation — either a sale or termination of operations. If the company continues to operate and there is no exit, this mechanism is not activated.
For investors, this is a tool for managing downside risk. For entrepreneurs, it is a matter of negotiation. This is why experienced parties always model several sale scenarios when concluding a deal.
Types of liquidation preference
There are two main types: non-participating and participating.
With non-participating preference, the investor either recovers their invested capital (e.g. 1x) or converts their preferred shares into ordinary ones and receives a chunk of the total sale proceeds.
Participating liquidation preference works differently. First, the investor receives their preference (e.g. 1x), and then participates in the distribution of the remainder as a common shareholder. This is significantly more profitable for the investor, but less attractive for the founders.
Often, the participating model has a cap, which limits the maximum payout (e.g. no more than three times the investment). This strikes a balance between investor protection and team motivation.
It is also important to consider the order of priority between different rounds of financing. Later rounds may have senior preference, which complicates the distribution structure further.
Example of profit distribution with liquidation preference
Suppose an investor gave $2 million with a 1x participating liquidation preference and received 40% of the company. The company was sold for $5 million.
Step 1: Return on investment: The investor receives $2 million (1x).
Balance: $5 million – $2 million = $3 million.
Step 2: Distribution of the balance proportionately to the shares: 40% of $3 million = $1.2 million.
The total payment to the investor is $2 million + $1.2 million = $3.2 million.
Without the participating mechanism, the investor would have received either $2 million or 40% of $5 million (i.e. $2 million). The difference is significant.
Preferred and common shares in profit distribution
Preferred shares
Preferred shares are a tool for protecting investors that combine the features of shares and debt instruments. Investors receive priority payment rights, the option to convert to ordinary shares and additional corporate guarantees.
This is standard practice in the venture capital environment. Without them, professional funds would rarely invest in equity. They must protect their investors' funds and minimise losses in unfavourable scenarios.
Common shares
These are usually owned by founders, employees and early participants in the business. They have no liquidation preferences and only receive payments after the claims of preferred shareholders have been satisfied.
This increases the risk. However, common shares offer the greatest growth potential if the company achieves large-scale success. In the event of a major exit, the difference between the share classes may be levelled out as the total sale amount covers all preferences.
Understanding the differences between these types of shares enables you to make informed decisions and accurately assess future profit structures.
How are profits distributed when a startup is sold?
An exit marks the end of the investment cycle, when paper valuations are converted into real money. At this stage, all the mechanisms discussed earlier, such as liquidation preference, share classes, the waterfall model and contractual terms, are activated.
Profit distribution upon acquisition
An acquisition occurs when a company is sold to a strategic investor or a larger corporation. In most cases, the funds are distributed immediately among the shareholders. The algorithm looks like this:
- The total amount of the transaction is determined.
- Liquidation preferences are then activated.
- The invested capital returns in accordance with the order of priority.
- Any remaining funds are distributed among the shareholders.
Example: A company is sold for $30 million. The total investment is $10 million. If investors have a 1x non-participating preference, they can choose to either receive a return of $10 million or convert their shares and receive a share of the $30 million. In most cases, if the sale is successful, investors convert their shares, as this is more profitable.
Another important consideration is the earn-out, which is a portion of the payment that depends on the company's future performance after the transaction. In this case, some profit may be deferred.
Profit distribution during an IPO
An IPO occurs when a company is listed on a stock exchange, such as the NASDAQ or the New York Stock Exchange. In this case, the company itself is not necessarily sold, but its shares become publicly traded.
Investors do not usually get money immediately during an IPO. Instead, they receive a liquid instrument — public shares that they can sell once the lock-up period has ended (typically after 90–180 days).
The actual profit received depends on the market price of the shares at the time of sale. For example, if a company is valued at $500 million when it goes public and an investor owns 5%, the formal value of their stake is $25 million. However, the actual profit depends on the sale price on the open market.
An IPO provides the opportunity for a gradual exit, enabling optimisation of tax liabilities and market risk.
How does dilution affect profit distribution?
What is dilution?
Dilution is a decrease in the percentage of ownership of a company resulting from the issuance of new shares.
For example, imagine you own 20% of a company with 1,000 shares. After a new round of funding, another 1,000 shares are issued. The total number is now 2,000. If you do not buy additional shares, your percentage ownership decreases to 10%.
The formula for calculating the new share percentage is:
New share percentage = Number of your shares / Total number of shares after the round × 100%.
Example of the impact of dilution on profit
Suppose you invested $500,000 for a 25% stake in the company. After several funding rounds, your share has diluted to 12%. The company was sold for $40 million.
Without dilution, 25% of $40 million would equal $10 million.
With dilution: 12% × $40 million = $4.8 million.
The difference is $5.2 million. This illustrates the strategic importance of the right to participate in subsequent rounds.
How are profits distributed between investors and VC funds?
Limited partners (LPs)
LPs are institutional or private investors who place cash in a fund but do not participate in its management. These investors can be pension funds, family offices, corporations or wealthy individuals.
Their income is generated after the return of capital and the distribution of profits, which are allocated in accordance with their share in the fund. LPs bear the risk, but their liability is limited to the capital invested.
General Partners (GPs)
GPs are the managing partners of the fund. They make investment decisions, conduct due diligence, support portfolio companies and organise exits. Their remuneration consists of two parts:
- a management fee (usually 2% per annum);
- carried interest (typically around 20% of profits).
It is the latter that motivates GPs to maximise the fund's returns.
Example of full profit distribution among several investors
Let's look at the structure:
- Investor A: $3 million (preferred, 1x).
- Investor B: $2 million (preferred, 1x).
- Founders: common shares.
The company was sold for $15 million.
Step 1: Return of capital — $3 million + $2 million = $5 million is returned to the investors.
Balance: $15 million – $5 million = $10 million.
Step 2: The balance is distributed proportionally to the shares. Let's assume the following: A: 30%; B: 20%; founders: 50%.
- A receives $3 million + $3 million = $6 million.
- B receives 2 million + (20% × 10 million = 2 million) = 4 million.
- The founders receive 5 million (50% of 10 million).
This example demonstrates how liquidation preference and proportional distribution work together. These calculations should be made before entering into an investment to clearly understand the future economics of the deal.
